Standing up to the test

Here's one assessment of the climate in which emerging markets private equity firms are operating: unprecedented value for money when buying assets thanks to market corrections; still-strong economic growth rates, even though a little slower than before; widespread avoidance of regulatory crackdowns; and a burgeoning consumer base for portfolio companies' products.

And here's another: an exit drought as IPO markets are shuttered and strategic buyers can't access finance; fundraising tougher than ever as investors struggle with the denominator effect and withdraw to “safe havens”; a deal hiatus as owners sit tight rather than sell at knockdown prices; political instability as economic strife causes civil unrest.

So which one is the true picture? In all likelihood, they both are. And this is the problem in arriving at a definitive conclusion about prospects for emerging markets private equity – much of the evidence points in different directions. However, PEI has identified three key issues which, as we explore below, will provide challenges. But these are challenges that can – and we suspect will – be overcome.

The effect of a downturn on growth: Talk that certain emerging markets had decoupled from the West has become quieter as the realisation has dawned that the economic downturn sweeping developed markets was bound to have repercussions for the world's developing markets as well.

Those countries heavily dependent on commodities – which were no doubt hoping that the much-hyped “commodities super-cycle” was more than just the latest fashionable theory – now face declining demand. This has clear growth implications for oil and energy producers such as Russia and the Middle East and industrial metals exporters including many countries in Latin America and Africa (though China's recent approval of major infrastructure initiatives will no doubt help this constituency).

Even the fastest growing emerging markets, most notably China and India, are facing problems as a result of the financial crisis. Exports are down and both countries are seeing the bursting of bubbles in their real estate markets.

Nonetheless, there is a compelling reason why John Zhao, chief executive of Beijing-based private equity firm Hony Capital, claimed at the recent PEI /EMPEA Emerging Markets Forum in London that China would be the most attractive private equity market globally in the coming period. Namely, the use of fiscal stimuli – enabled by China's current account surplus and huge foreign reserves – in order to ensure a strong GDP growth rate in the years ahead.

Many speakers at the Forum referred to the strong relative growth of emerging markets. While a decline from an eight or nine percent growth rate to six or seven percent is obviously not a good thing, it nonetheless compares ext r eme ly favourably to the prospect of negative growth in many Western markets over the next year or two. From the limited partner perspective, nothing that has happened since the middle of 2007 should persuade them that the emerging markets growth story has somehow ground to a halt.

Stock market volatility: In many emerging markets, stock markets have come to play a much more important role in delivering exits for private equity firms than in other, more developed markets. And this is not surprising when you consider how rapidly stock markets in certain emerging regions have risen in recent years.

But what happens when stock market booms come to an end and shares begin to prove the old adage that they can go down as well as up – and spectacularly down in many recent cases? Well, private equity firms in countries like China and India are currently finding out. With new issues effectively off the agenda and potential trade buyers constrained in their ability to borrow, GPs are facing the prospect of holding portfolio companies for longer and seeing their returns decline as a result.

But as stock markets fall, private equity's stock as a provider of capital to growing companies is going up. Until now, emerging markets businesses – many of them family businesses – have tended to view private equity with a degree of suspicion, not wanting to involve outsiders in the running of their operations. But today there is little choice and private equity has, as a result, assumed the mantle of prized provider of liquidity.

Experience of cycles: Beware an unfortunate correlation – in emerging markets, many GP team members and management teams of young, dynamic portfolio companies are also “emerging”. In other words, long experience and track records can be in short supply. In times of economic upswings, this may not matter too much. But when everything turns sour, a few grey hairs can suddenly become a valuable commodity.

“You don't want to be backing new management teams consisting of 20-somethings who have not seen anything,” says Yvonne Bakkum, director of private equity at Dutch development finance institution FMO. “In an environment like this, people have mentioned that would be like asking them to climb Everest without oxygen. But if you invest in a country like Colombia, you can't necessarily find experienced teams with long private equity track records. But you can find good professionals with other relevant experience. You just have to try and work out which team is best positioned.”

However, others point out that managers in emerging markets have seen a few crises in their time – the only difference being that those crises have often been homegrown and tended to relate to currency or political developments. Indeed, one joke doing the rounds is that emerging markets are celebrating the fact that this is the first crisis in living memory not of their own making. An arguably more serious observation from one GP source is that “emerging markets managers are better prepared to deal with this crisis than they have been for the last 10 to 15 years”.

It would perhaps be naïve to imagine private equity firms in emerging markets looking forward to the period ahead with relish. Nonetheless, there is an opportunity: stand firm in the face of the financial tsunami, and private equity in developing regions will have passed a very important credibility test.